This is the second of a three-part series on the incentives involved in creating meaningful health care reform. If any major health care legislation is passed in the United States in 2009, it will almost certainly involve some form of an insurance exchange. This post focuses on the need to create competition in the private insurance market, incentives for insurers to focus on improving their insurees’ health, and strategies to help mitigate avoid adverse selection.

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Some believe that too much competition has been the catalyst for rising health care costs and inefficiency in the American health care market. I disagree. I believe that the U.S. insurance market actually suffers from too little competition. But if health care reform is going to work, we need to figure out how to make the market for private health insurance more competitive without resulting in some of the more undesirable byproducts of competition.

The discussion of “private” insurance in the United States often takes for granted that the market for health insurance is competitive. As is so often the case in health policy, a “private” market is confused with being a truly “competitive” market, but that does not necessarily have to be the case. In comparison to the markets for private health insurance in Switzerland and the Netherlands, the U.S. health insurance market is anything but competitive. Take a look at these alarming statistics from research conducted by the American Medical Association:

• In 95 percent of health insurance markets, one insurer has more than 30 percent market share.
• In more than 50 percent of markets, a single insurer has captured more than half the market.
• In seven U.S. states, a single insurance company has captured more than 75 percent of the market.

This lack of competition is leading to inefficiency and waste in the health insurance industry. Over the last 10 years, as the health insurance industry has become less competitive, health insurance premiums have gone up 120 percent, compared with a wage growth of only 29 percent during the same period. Similarly, the administrative costs in the market for individual insurance plans is in the neighborhood of 25–30 percent, which is higher than the administrative costs in the more competitive group-plan sector of the market (which are also too high).

There are a number of reasons why the market for private health insurance in the U.S. is not competitive. First, mergers have cut down the number of insurance companies offering coverage, and there are simply too few insurance companies left. Second, insurance companies can’t compete over state lines. Third, for insurees, switching between insurance companies is cumbersome and administratively complex.

A health insurance exchange, as many health reform proposals suggest, could help alleviate many of these shortcomings. An exchange would make it easier for insurance companies to enter the market, it would allow competition in larger regions of the country, and it would make comparing plans and switching between them far simpler for insurance customers. The insurance exchange would encourage insurees to switch plans if they were not happy, but like the market for insurance in the Netherlands, it could limit how often such a thing could occur to, say, once a year. Furthermore, other policies to ban insurers rejecting applicants and introducing community-rated premiums would make insurance coverage fairer.

But encouraging individuals to switch insurance plans while simultaneously banning insurance companies from rejecting applicants with preexisting conditions does carry some risks. Take, for example, a situation in which a healthy individual who has been a participant in a high-deductible, low-cost, catastrophic insurance plan for many years suddenly learns that he will need a $20,000 hip replacement. His existing insurance coverage would only cover half the bill, leaving him with $10,000 worth of care to pay for out of pocket. If an insurance exchange is not correctly organized and regulated, the danger will be that this individual will simply find a new plan with more generous benefits before his surgery. The new plan would cover the whole surgery with a minor copayment, and then he could simply switch back to his old (cheaper) high-deductible plan after a short period of time, saving himself $10,000 in the process.

This type of scenario is what in economic terms is called “adverse selection,” and it could wreak havoc on the insurance market, causing insurance costs to rise for everyone. So what is the alternative? The insurance industry needs to take a page from the mobile phone industry. One way to capture clients in a competitive market with a significant chance of switching to another provider is to sign customers to long-term contracts. Health insurance companies could offer plans with coverage at a lower cost for a long-term commitment—say, for five years—and charge a penalty if customers switched coverage early.

Offering these types of plans in a truly competitive environment would have a distinct advantage over the way we currently structure the insurance industry: insurance companies would now have an incentive to promote health and wellness among their customers, rather than simply paying to treat illness. Insurance companies that sign insurees up for long periods would have strong incentives to focus on keeping their insurance pool healthy, since the healthier their insurees, the less the insurance company would need to pay out for medical care. It’s even possible to imagine a scenario where insurance companies could bid for the right to keep offering their care to their patients when they shifted to Medicare. This would create even sharper incentive to focus on health promotion in one of health care’s most expensive market segments.

This type of long-term, cell phone-style contract health insurance would have some downsides. First and foremost, it would be difficult in a country as big as the U.S to accommodate insurees who move out of state and want to take their insurance with them. To work efficiently, these types of insurance plans would have to be accompanied by reforms to allow insurance companies to provide coverage across the country without the hindrance of state lines.

A second concern would be enrollees who regretted their choice or were not happy with the service that they were provided. While a significant concern, this, too, has a solution. For one thing, just as the federal government regulates credit card fines, it could limit the maximum penalty for breaking an insurance contract, ensuring that the fine would be high enough to reduce harmful switching but low enough to give insurees a realistic ability to escape from an insurer offering a substandard product. In addition, the health exchange could heavily promote insuree feedback, in much the same way as Tripadvisor.com or Amazon.com solicits comments from customers. Feedback would help to keep insurers honest, dissuading them from providing substandard care that could then deter new potential insurees from signing up for coverage in the first place.

Incentives are going to be the key to achieving meaningful health care reform. We need incentives that promote best practice medicine, penalize inefficiency, and reward keeping patients healthy. And all this must meet the approval of the U.S. electorate and mirror American values. Not an easy task, but not impossible either.

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Special Contributor Zack Cooper is a research officer with the London School of Economics. His monthly column for the Health Policy Forum considers health policy from the international perspective. “Special Contributors” are regular contributors to the Health Policy Forum who pose their own opinions and policy positions in the realm of health care and health policy. As a leading nonprofit health care research and consulting institute dedicated to improving human health, Altarum encourages open discussion and debate about the many challenges in health care today. All postings to the Health Policy Forum (whether from employees or those outside the Institute) represent the views of the individual authors and/or organizations and do not necessarily represent the position, interests, strategy, or opinions of Altarum Institute. Altarum is a nonprofit, nonpartisan organization. No posting should be considered an endorsement by Altarum of individual candidates, political parties, opinions, or policy positions.